Mutual Funds With Multiple Classes Are Just Marketing Gimmicks / Vanguard Group's new Admiral shares will add to confusion

Published 4:00 am, Tuesday, October 31, 2000

One of the worst inventions ever to sweep the load-fund industry was the creation of multiple share classes.

Today, most load funds have various classes -- such as A, B and C shares -- that have identical portfolios and differ only in the way investors pay commissions and fees, and in their returns.

Now Vanguard Group is bringing the same idea to the no-load fund business.

Let's hope it doesn't spread.

If you ask me, multiple share classes are a marketing gimmick that discourages innovation and creates widespread confusion with little or no benefit to shareholders. But that's just my opinion.

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On Nov. 13, Vanguard will roll out a class of "Admiral" shares that will charge lower annual fees but require greater balances and/or longer holding periods than its regular "Investor" class of shares.

Vanguard says Admiral funds will reward big, buy-and-hold shareholders because they generally cost less to serve than smaller investors who flit in and out of funds.

Initially, Admiral shares will be available on only seven index funds, but next year, they will be offered on all Vanguard stock, bond and balanced funds.

For example, investors in the popular Vanguard 500 Index fund currently pay 0.18 percent a year in expenses, or $1.80 per $1,000 investment.

Those who get into the Admiral shares will own the same portfolio, but will pay only 0.12 percent a year in expenses. The difference is 0.06 percent or six "basis points."

Fund performance is reported after expenses, so lower expenses boost the bottom line.

One problem with Admiral shares is that they will benefit a handful of large shareholders, possibly at the expense of smaller ones.

Vanguard has stated that "the expense ratios for the existing Investor Shares of the seven index funds will remain unchanged from their 2000 expense ratios." However, "the expense ratios for Investor Shares of other funds may rise one to three basis points upon the introduction of their respective Admiral shares in 2001."

Even if expenses rise a tad for some shareholders, Dan Wiener, editor of the Independent Adviser for Vanguard Investors (www.adviseronline.com), doesn't think the expense differential between Admiral and Investor shares is meaningful. "It really doesn't matter. A few too many shares of Nortel is going to have a bigger impact than five basis points in expenses."

A more serious problem is the potential for shareholder confusion, which stands in stark contrast to Vanguard's usual no-nonsense approach to investing.

For starters, Vanguard already has three Treasury funds and one money market fund with the Admiral name. These funds are unrelated to the new Admiral share class. Vanguard spokesman John Demming says the company "is aware of" the name overlap, but thinks "it won't be an issue going forward."

More perplexing are the qualifications for Admiral shares. To get them, you must meet one of three criteria:

-- Have at least $250,000 in the fund. (You can't have $250,000 divided among two or more funds and qualify for Admiral shares.)

-- Have at least $150,000 in a fund account that has been open for at least three years.

-- Have at least $50,000 in a fund account that is at least 10 years old.

Unfortunately, only three of the initial seven funds that will offer Admiral shares are at least 10 years old, says Wiener. They are 500 Index, Extended Market Index and Small- Cap Index. The others -- Balanced Index, Growth Index, Value Index and Total Stock Market Index -- were all first offered in 1992.

Another caveat: Investors with $250,000 in a fund can transfer into Admiral shares by phone, mail or the Web. But those who meet the lower requirements can only make the switch through Vanguard's Web site. (There are no fees or tax consequences for exchanges between share classes.)

Vanguard will notify shareholders who qualify for Admiral shares, but they will have to take the initiative to make the transition.

However, Wiener says Vanguard will automatically switch shareholders out of Admiral and back to Investor class if they fall below the minimum Admiral requirements.

Demming says Vanguard will give Admiral investors a chance to get back into compliance before drumming them out.

In the future, when Vanguard shareholders check their fund's performance, they'll have to make sure they're checking the right class of shares. The performance of Admiral and Investor shares will differ by the gap between their expense ratios.

The proliferation of share classes has been a major problem for newspapers, because each share class must be listed separately. Some newspapers have had to increase the space they devote to fund listings, some have stopped carrying smaller funds, and some (such as The Chronicle) have attempted to list only one class for each share.

Until the early 1990s, most mutual funds had only one share class. But in 1993, the Securities and Exchange Commission "made it much simpler to create multiple share classes," says Paul Held of Cerulli & Associates, a consulting company for mutual funds.

Load funds, which are sold through brokers and financial planners who charge a commission, quickly began offering new share classes to compete with no-load funds, which are distributed directly through fund companies without a commission.

In a typical load fund, the A shares have an up-front commission, the B shares might charge a commission when shares are sold, and C shares might have no commission but charge higher annual expenses.

"Instead of creating new investment portfolios, (load funds) put most of their effort into rejiggering their pricing," says Held.

From 1995 to 1997, he says, 45 percent of new fund offerings were new classes of existing funds, and only 18 percent were entirely new funds. The rest were funds that changed their names or investment strategies.

Vanguard is the first major no- load group to offer multiple classes for all of its funds, although some no-loads have institutional or I-class shares that require an investment of $1 million or more.

"This is path breaking among the large companies," says Scott Cooley, senior analyst with Morningstar.

He says Vanguard is trying to keep high-net-worth customers from defecting to exchange-traded funds, which are ultra-low-cost funds that trade on stock exchanges, or to private money managers.

(Vanguard's own line of exchange-traded funds are being held up by a legal dispute with Standard & Poor's.)

A Fidelity spokeswoman says her company has no plans to offer new share classes but "it is not something we would rule out."

Cooley says that on balance, Vanguard's new share class "is good because it rewards the right people and makes the fund industry more competitive. It does give people an incentive to do the right thing," which is invest for the long term.

"My question is, does your typical shareholder respond to this? My guess is not. If people are trading every three years on average and incurring all those transaction fees, a small break in the expense ratio is not going to change that."

Full disclosure: I own shares in Vanguard index funds, but not enough to be an Admiral.

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